Editor’s Note: This Q&A is the first in a series of articles that Rethinking65 is doing on viewpoints of industry leaders who attended the Schwab Impact 2023 conference. Kathy Jones is a Schwab managing director and is responsible for interest rate and currency analysis, as well as fixed-income education for Schwab clients. Before joining Schwab in 2011, she was a fixed-income strategist at Morgan Stanley.
Dorothy Hinchcliff: Thanks for meeting with me. To start off, I am curious about your take: More and more commentators are looking at this as a transformative moment for fixed income. What do you think about that?
Kathy Jones: I think the era of zero interest rates and quantitative easing is behind us, barring some huge disaster that might occur, which we hope doesn’t occur. So, is it a new era or is it a return to the old era? That’s kind of an open question in my mind.
On the one hand, we’ve recovered from the great financial crisis and a pandemic. Now we’re in a tighter labor market, which means more jobs. We have big investment in infrastructure going on, which should sustain growth.
I think where I might differ from other people is they assume that means higher inflation. I’m not sure that I buy that. I think investments should be productive and should actually help hold down inflation. I think we probably have passed the point of full employment.
Going forward, we still have an aging population, and that means demand for savings, rather than as much consumption. This seems to me like we’re returning to a pre-pandemic, pre-financial crisis era, where we had nominal GDP of 5% or 6% and inflation of 2.5% or 2%. Real growth going forward, but not an era where we see persistently high inflation. It depends on what the Fed does, but zero interest rates are behind us. We should look forward to higher rates going forward, but I’m not in the camp that says we’ll have higher inflation necessarily. Hyphens needed?
Hinchcliff: Are you in the camp that is leaning toward the idea that rates will be higher for longer?
Jones: I don’t know the definition of higher for longer. Everybody seems to have their own definition of that. So higher for longer versus zero, yes. Five percent or 5.5% for longer? Maybe not.
We have a base case scenario, and I have to tell you, our confidence level is not high because there have been so many twists and turns. This is our base case scenario: It’s that the cumulative effect of all the tightening, the slowdown in Europe — recession in parts of Europe — and China being under the weight of this overhanging debt, will be that you have a global economy that’s more prone to slowing than speeding up in 2024.
I think the most logical outcome is the Fed will cut rates sometime next year from five-and-a-half maybe down to four-and-a-half. And then we try to find that equilibrium level. Longer term, it could be two-and-a-half, but I think that’s optimistic to think we will see that any time soon.
Hinchcliff: When people age, they generally have a need for income. How will that impact fixed income? On the other hand, people still need some growth investing to compensate for inflation.
Jones: If you’re transitioning into retirement and you need more income, at these levels, you can generate not only nominal returns that are pretty high, but real returns. We could use the TIPS market, as one way. If you’re locking in five, five-and-a-half percent nominal yields, that’s a pretty good income, that you have as your base. Then you have your equities for longer-term growth as that hedge against inflation. You need some growth in the portfolio and then the question is, what’s the allocation? And that’s a very different picture now, right? When you can get 5% in fixed income without risk, that makes the hurdle rate for the equity market higher.
Hinchcliff: A lot of older investors have relied on dividend stocks for income. But would bonds look a lot more favorable now?
Jones: Yes, it’s pretty clear. You don’t have the volatility or the downside. But again, if a portion of your portfolio is in equities for long-term growth, then sure, having a dividend strategy in there makes sense. As long as it’s very long term.
Hinchcliff: What are your thoughts on bond prices? They have really suffered. [Last year, the price of iShares Core US Aggregate Bond ETF (AGG), a widely used benchmark, was down 13%. For 2023, it was down more than 2% year to date at the end of October.]
Jones: Barring a default, a bond returns to par. If you are marking to market, I guess it’s upsetting. But if you’re investing for a time horizon and you can hold, you know exactly what you get back at maturity. And then they’re less inclined to look at price declines and say, “Oh my gosh, I am losing the money, I have to sell,” and lock in a loss.
Hinchcliff: I understand the idea of buying individual bonds, and if you hold them to maturity, they can look pretty good. But what if it’s a bond ETF or a bond fund?
Jones: There are a million different versions of products. We’ve done research using the AGG as a benchmark. So if you buy a bond ladder or fund that has a similar duration and credit quality to the AGG, for example, the fund will give you a return that’s very similar to holding individual bonds over time. The hard part is people don’t see that in real-time. They see the price fluctuation, and it’s human nature to say, “I’m losing money, I need to sell.” But when you’re holding the individual bonds, people will say, “Oh, but I know I’m getting my principal.”
Hinchcliff: What kind of questions is Schwab hearing from financial advisors about fixed income?
Jones: They’re reflecting what their clients are asking them. When can I go longer in duration? What’s the impact of quantitative tightening? How far can the Fed go before something breaks? What’s the best risk-reward? They’re trying to answer their clients’ questions and build something that will provide a lasting portfolio.
Hinchcliff: What is Schwab seeing — the allocation overall of fixed income versus equities?
Jones: I don’t have the answer. But I know fixed income has been a booming part of the business ever since the Fed started to raise rates.
Hinchcliff: Are there any particular fixed-income strategies that seem to be attracting more money than others?
Jones: Yes, bond ladders. It has been something we’ve advocated for a long time.
We think it’s a good strategy for a lot of people to build an income stream. The beauty of a bond ladder is it is elegant with simplicity. We think it’s intuitively straightforward. And we think it’s a way to spread out risk and mitigate some of the hurdles of timing the market. So yeah, I’m a big fan of bond ladders; I have been for a decade.
Hinchcliff: A lot of advisors have relied on funds and ETFs for bond exposure. Do you think with some of the tools that Schwab offers now, it is easier for individual advisors to have a good enough understanding of the bond market to build ladders to be able to invest directly rather than through a fund?
Jones: Yeah, I think a lot of times with an advisor, it comes down to what their resources and capabilities are. If you have a fixed-income specialist, someone who really understands the market, then we’ve tried to build it so that they can access the market and we have specialists who can help.
But for a lot of advisors who are more financial planners, they are working on a lot of other things. It’s not their specialty. They may be inclined to use the funds and we try to provide as much clarity on the various funds as we can. We have a select list of mutual funds that have been vetted and screened by us. It’s not like we’re saying, “Oh, you should buy this,” but we at least have screened them, looked into them, and monitor them to make sure they’re doing what they say they’re supposed to be doing.
Hinchcliff: How does the municipal bond market look?
Jones: It looks attractive on a couple of fronts. One is the credit quality. Coming out of the pandemic, state and local governments still have a lot of funding. The rebound in the economy generates revenue through sales taxes, property taxes, income taxes — all the places that they derive their revenue — so that’s improving. By and large, state and local governments were slower to increase spending coming out of the pandemic. Hiring has been very slow in the public sector. Hiring is just starting to catch up, so budgets, by and large, are in good shape. Upgrades are more numerous than downgrades. The credit quality is good. Obviously, there’s always going to be a few issues out there. The yields really are very good.
Hinchcliff: With interest rates having gone up and if they do stay up for some amount of time, are you concerned about the corporate side of the market?
Jones: We’re concerned more about high yield and bank loans. By and large, the average maturity on corporate bonds for investment grade is very long, so they have lots of pretty favorable rates. Obviously, if we get a deep recession, there’s going to be some downgrades there, but it’s probably relatively small. But in high yield, you’re really not getting enough compensation yet for risk. Defaults are rising. Small-business bankruptcies are rising. So, there’s a lot of weakness. Those are the companies that are going to have most of the problems. We’re cautious on high yield and we’re cautious on bank loans because, for the short duration, they’re very risky. If they have to roll over credit at 8%, 9% 10%, it’s going to be a real challenge.
Hinchcliff: When you say you see defaults rising, what kind of pace are you seeing compared with other times in the market?
Jones: The default rate is up at about 4% now. That’s up from almost nothing. In a typical cycle, you’ll see it pick up to 6% or 7%; in a bad cycle, it can go higher than that.
Hinchcliff: What about the geopolitical environment? I know it’s a big wildcard and especially now, we don’t really know where things are with the war in Israel and Gaza. Are you watching for any particular developments?
Jones: I think the obvious risk is if it becomes a wider war and it involves Iran, and we see a spike in oil prices. That not only sends inflation up, but it probably hurts the economy. So that would be a risk. Frankly, it’s hard to know exactly how that would play out. What happens then? And then you throw Ukraine and Russia in there, the energy supply to Europe, and you’ve got a pretty scary mix of things. But how does the market react, is the question. Is there a flight to safety in the short term and the dollar spikes? Or does something else happen? I can’t predict.
Hinchcliff: What’s your thought on the Biden administration asking for a large increase in spending for Israel and Ukraine? Is it concerning when it comes to the deficit?
Jones: The deficit question is a tough one, because, intuitively, you say well, rising deficits have to be funded, and therefore, all else being equal, interest rates should rise. The problem is when you look at the supply of Treasuries versus yields over history, you don’t see a correlation, short term or long term. I think right now, one of the concerns is we have a rising deficit, but we have a price-insensitive buyer, the Fed. So you have to find other buyers, and that’s been households. Household allocations to Treasuries are way up.
Where is the equilibrium there? Is 5% enough? That seems to be doing the job right now. Although I will say, obviously, that the trajectory we’re on with the deficit is not sustainable. On the other hand, is it a huge factor for the market? Probably not.
Hinchcliff: So, you don’t think the deficit is going to be a huge factor in pushing up rates?
Jones: Probably not. It’s a big narrative. But I have spent more than 40 years in this business. I have burned up a lot of computer time and brain cells trying to find a correlation between Treasury supply and interest rates. Statistically speaking, it’s very difficult to find a correlation. So, I’m going to stick with the fact that the math tells me that’s not the biggest worry. Not that I’m saying the deficits were ever a good thing, but we’re not an emerging-market country. We have an independent central bank, we have the dollar as a reserve currency, and we have a lot of buyers.
Hinchcliff: So, you don’t think we’re heading toward a crisis.
Jones: Oh, we’re always heading toward a crisis! It’s always out there in front of us. Maybe it’s like Winston Churchill said, in the end, the U.S. does the right thing after it’s exhausted all other possibilities. Perhaps when Congress has exhausted every other possibility, they’ll figure out what to do. It’s really tough, right? Because you have the big spends on our Social Security, Medicare, Medicaid, veterans benefits and defense. That makes up the vast majority of our spending. Nobody wants to cut any of this.
Hinchcliff: Do you think defense spending is going to increase with everything going on, and will that pull inflation up?
Jones: The rate of change in defense spending has not been that rapid. We always spent a lot of money on defense, so the rate of increase is not a lot; it’s not that substantial. And nobody wants to raise taxes. Or even wants to fix loopholes that are widely known.
So, nobody wants to raise revenue. No one wants to cut spending. And there we have it. Politically, it’s not tenable on either side. At some point, something happened and we’ll change that.
Hinchcliff: Do you think the political situation with polarization on both sides will result in things being volatile for a while?
Jones: It seems like it. We’ll be very much rocking and rolling between Congress and the Senate. Right and left, up and down. And you know, part of why rates are high is because people are pricing in the uncertainty. I think that is something that kind of persistently gives a little bit more yield in the market.
Hinchcliff: Is there anything I’ve missed that you want to talk about on fixed income?
Jones: I guess my key sort of message for advisors is that despite all the scary things that are going on, and all the dark clouds and the uncertainty ahead of us, this is an opportunity we haven’t had in well over a decade — without a tremendous amount of risk for clients. I think a lot of them do feel that way. But when you’ve got blaring headlines all the time about bonds being down, it’s hard to convince people that this is an opportunity.
Hinchcliff: Thanks again, Kathy, for your time.